Foxconn: How to Beat the High Cost of Happy Workers

For Li Xiaozui, life as a factory worker assembling products for Apple (AAPL) and other technology brands has gotten better over the past year. Li, 20, is one of 500,000 people working in the southern Chinese city of Shenzhen for Foxconn, the Taiwanese contract manufacturer that stumbled into the media spotlight last year—and onto Bloomberg Businessweek's cover—following a series of worker suicides. Under pressure from Apple, Foxconn scrambled to improve morale and head off criticism about its labor conditions. It more than doubled wages in Shenzhen last year and instituted a program it calls "Care-Love." Li says she's not only making more money but has made new friends and gone on company-sponsored outings with colleagues. "I've been to the beach and the mountains," she says. "People are definitely much happier."

Employee turnover and suicides are down—yet so are profits and the stock price of Hon Hai Precision Industry, the flagship of the Foxconn group. On Apr. 27, Hon Hai announced that fourth-quarter earnings dropped 26 percent, to $742 million, over the same period a year earlier, even as revenue jumped 56 percent, to $33.1 billion. Its Taipei-listed shares have fallen 20 percent in the past year, too, making it one of the worst performers among Taiwan's 50 largest companies. Foxconn International, the Hong Kong-listed unit, in March reported a full-year net loss of $28 million on sales of $853 million.

Chairman Terry Gou is working to show investors and outsourcing customers that he's positioned the company for a rebound. The first step: get costs under control. Foxconn workers in Shenzhen aren't the only ones getting raises; pay has been rising in other cities, too. "The coastal areas are facing the worst labor shortages for three decades," Credit Suisse economist Dong Tao wrote in a May 1 report. Gou, 60, has been shifting production away from southern China toward interior cities such as Chengdu, Wuhan, and Chongqing, where labor is about one-third cheaper. To help pay for the long march inland, Hon Hai last month announced the lowest annual dividend in at least 15 years. Gou is also looking at expansion in Slovakia, Turkey, and Brazil. Last month Brazil's President, Dilma Rousseff, announced Foxconn may spearhead a $12 billion plan to expand electronics manufacturing in her country.

Foxconn isn't the only Taiwanese electronics company dealing with higher wages in China. The world's two largest producers of laptop computers, Quanta and Compal, are among many of the island's outsourcing specialists feeling their already narrow profit margins squeezed. For the Taiwanese, the ability to withstand the pressure depends on "whether you can pass on the costs to customers and whether you can relocate your manufacturing to some other areas with lower costs," says Henry King, an analyst with Goldman Sachs in Taipei. In the race away from coastal China, Gou is off to a fast start. Chengdu, Chongqing, and other interior cities accounted for just 10 percent of output last year but should make up about one quarter of production this year, says Vincent Chen, head of Greater China technology research at Yuanta Securities in Taipei. By 2012, he expects half of Foxconn's output will come from the interior. "Hon Hai already has an upper hand," says Chen.

Unlike other Taiwanese contract manufacturers, Foxconn is benefiting from the rise of the tablet PC. Consumer demand for laptop computers is especially weak, as buyers turn instead to Apple's iPad and its imitators. That's bad news for companies such as Quanta and Compal that specialize in laptops. Foxconn hasn't been a major player in laptops, so it hasn't suffered from the slump in demand. It does, however, make a lot of iPads and iPhones. While Apple is trying to reduce its dependence on Foxconn by finding other suppliers, Gou's company is the only manufacturer that makes the iPad and one of two producers of the iPhone. Those ties with the world's hottest tech company may help Gou through the rough times.

The bottom line: As wages rise in coastal China, Taiwanese manufacturers are shifting to inland cities. Foxconn started earlier and is moving faster.

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